Don Quixote is alive and well … and living in Spain

Demonstrators carry banners during a protest of civil servants against government austerity measures in downtown Madrid October 5, 2012.

It was said of the Bourbons that they learnt nothing and that they forgot nothing. Judging from the Spanish government’s most recent economic policy pronouncements amid widespread social and regional unrest, one has to wonder whether the same might not be said of the Spanish government. For it seems to be persisting with the failed economic policies of the past year that have not only got Spain into its current difficult economic straits but that are now also running the real risk of literally tearing the country apart.

The Spanish economy is presently in a very sorry state. Despite having barely recovered from the Great Economic Recession in 2008-2009, the Spanish economy has again dipped decisively into economic recession. All indications would suggest that the Spanish economy is now likely to contract by around 1.5 percent in 2012 with no end in sight for the economic recession.

Leading the economy’s decline has been the bursting of a housing bubble that made that in the United States pale by comparison and that is now causing Spain’s banks to cut back sharply on extending credit to households and corporations. Meanwhile, Spanish unemployment continues to increase at an alarming rate with 25 percent of the Spanish workforce now on the unemployment line and with youth unemployment in excess of 50 percent.

A Political Problem

If Spain’s economy is in poor shape, its politics look at least equally troubling. Anti-austerity protests have now become the order of the day, while the popularity of the Conservative Rajoy government, which barely one year ago was swept to power in a landslide election, continues to plumb new lows.

Worse yet, Spain’s regions have become increasingly restive in their demands for increased autonomy as the country’s more prosperous regions object to their being forced to transfer a disproportionately large part of their tax collections to the federal government. The Catalonian government has now plunged the country into a constitutional crisis by calling for an election on November 25 to gauge Catalonian public opinion as to whether or not Catalonia should secede from Spain.

At the heart of Spain’s economic difficulties is the pro-cyclical fiscal policy that is being foist upon the country by its European partners to correct Spain’s troubled public finances. In that context, the European Central Bank (ECB) could not have made it clearer to the Spanish government that any support that the ECB might provide to Spain through proposed large-scale government bond purchases is contingent upon Spain subscribing to an externally monitored fiscal adjustment program by the European Stability Mechanism and by the IMF.

Austerity Isn’t Working

The trouble with fiscal austerity in Spain is that it has not been working in the sense that it is causing the Spanish economy to contract, while at the same time worsening Spain’s housing market bust and its credit crunch.That in turn is complicating Spain’s ability to meet its budget targets since a weaker economy has substantially eroded Spain’s tax base and added to the regions’ budget difficulties. It is now likely that Spain’s budget deficit for 2012 will be more of the order of 7.5 percent of GDP rather than the 6.3 percent of GDP budget deficit target.

Spain’s poor economic performance over the past year should not have come as a surprise to the Spanish government. For it is exactly what was to be expected from implementing severe budget austerity at a time when banks are cutting back on credit, the housing bust continues unabated, and when the euro straitjacket precludes Spain’s ability to use exchange rate policy as a means to boost export growth.

More of the Same

Undaunted by the deepening economic recession and by rising social and regional tensions, the Spanish government is now doubling down on a bet that failed so miserably this past year. Indeed, in an effort to keep his European partners happy and in the hope that he can avoid having to go cap in hand to the IMF, Mr. Rajoy is now proposing budget cuts totaling EUR40 billion, or close to four percentage points of GDP, for 2013.

One has to wonder why Mr. Rajoy thinks that proposing an even more pro-cyclical fiscal policy now than he did last year in the midst of a deeper economic recession and of a very much worse external economic environment than the country faced last year will produce a more favorable economic outcome this time around. Sadly, by the time he finds out that this policy approach will only deepen the country’s recession, his government will have lost what little credibility that now remains and the country’s social and regional crisis will have come to a full boil.

Given that Spain is the euro area’s fourth largest economy, this has to be a major concern not only for Spain but also for the whole euro project and for the global economy.